1031 on two family house

[Frank Rubino]

Here's my situation:

I purchased a two-family house in 2016 and lived in unit 1, while renting out unit 2. Then in February of this year, I moved, and started renting out unit 1 as well.

I want to sell the house and avoid taxes. I know unit 2 will qualify for a 1031 exchange as it's been rented since 2016, but what about unit 1? It's only been rented since Feb 2022. Would it make more sense to use section 121 for unit 1? 

[Dave Foster]

@Frank Rubino, You will have to treat those two units differently since the part you rented is not simply an allocated area of one main living area.  So you cannot do just a 121 on the whole property.  And you also cannot do a 121 on the unit that you rented.  But.....

Congratulations!! you get the best of both worlds!!!  The portion that you lived in will get the primary residence exemption.  The first $250K of profit ($500K if married) will be tax free.  Your only tax on this would be the 5 months of depreciation that would have accrued since February.

The unit you rented would qualify for a 1031 exchange.  

The key in doing a 1031 if you need to, is that you'll need to be able to demonstrate that your intent in converting it to rental was to hold it for productive investment use.  If you only converted to get a couple of months in and then sell and do a 1031 the IRS could determine that your intent was primarily to resell and not hold.  That would disqualify the 1031. 

So, the potential for you is some of the profit tax free.  The rest (and the depreciation recapture) indefinitely deferred in the 1031 exchange.  How can it get any better??!!!